Commodity Futures Trading Commission
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Risk Assets or WMD: The Case for Derivatives
Keynote Address by Sharon Brown-Hruska, Commissioner
U.S. Commodity Futures Trading Commission
New York City, December 7, 2005
Good afternoon and thank you for that kind introduction. It is my pleasure to speak on the topic of the regulation of derivatives-based investments. For a long time derivatives instruments such as futures and options contracts were primarily thought of as a means to hedge price risks or, when someone was not hedging, to speculate on the price of an asset or commodity. The latter purpose, that of the speculator, has always been considered of less importance than that of the hedger, and many a historic battle has been fought to curtail speculation through regulatory means ranging from speculative position limits (which still exist on many commodities) to outright bans on trading derivatives on a particular asset (for example, onions) or a particular class of derivatives (for example, the ban on agriculture trade options).
Derivatives, by their very nature, are products whose value is based on the prices of assets such as energy products, precious metals, and agriculture commodities, and financial assets such as stocks, bonds, and currencies. We have also seen numerous innovations in products that combine features of derivatives and cash assets (structured products) and in the area of event markets. As a vehicle to manage risk, both to shed it and to assume it, derivatives, or what I call “risk assets,” provide a low cost vehicle to get market exposure without being in the underlying business itself.
The concept that these risk assets can be incorporated into a portfolio as a more traditional investment vehicle has gained increased standing, but this concept is not without its detractors. Usually the detractors get the most attention, raising concerns about the supposed risks that derivatives themselves pose to investors, the markets, and the economy. For example, in the 2002 annual report of Berkshire Hathaway, Warren Buffet referred to derivatives as “financial weapons of mass destruction,” expressing concerns that the credit risk associated with certain OTC derivatives is like a ticking time bomb ready to explode that could take the economy with it. In his view, the government had found no way to effectively control or monitor these instruments.
The government, Congress, federal authorities such as the Federal Reserve Board and the Commodity Futures Trading Commission, as the regulator of the futures and options markets, have had to respond to both the criticism and corollary efforts to limit the use of derivative assets through increased scrutiny and regulation. For those of you who do not know me, I am a Commissioner at the Commodity Futures Trading Commission, the oversight regulator of the futures and options industry in the United States. Before coming to the Commission in August 2002, I taught derivatives, risk management, and private capital market finance at George Mason University, and before that, Tulane University. The opinions and views I express are my own and do not necessarily represent those of the Commission or its staff.
The way we go about regulating the industry can have a large impact on how the markets function and how financial assets can be used. This is important because what a regulator does can potentially determine not only what one can trade, but perhaps more importantly, how much it will cost to trade. Regulations usually take the form of capital requirements, disclosure documents, execution rules, registration requirements, etc. As a regulator, I believe responsible regulation entails a duty to taxpayers, market users, and the public who benefit from markets to be mindful of the benefits and costs of rules and requirements that we promulgate. Regulatory solutions must be targeted and effective.
As regulators of risk assets, we must use caution to avoid instances where we inadvertently create moral hazards, become captured by the industry itself, or become overly protective of the markets. I hope you will forgive my adaptation of an overused cliché, but too often regulators are great “inside-the-box” thinkers. That is, there is the temptation to adopt a set of regulations and stick with it through thick and thin. By doing this, however, we run the very real risk that markets will lose their ability to innovate because the innovation does not fit neatly into our box. In my experience, incumbents in a market and in government will argue that if the innovation is contrary to the rule, then the innovation is risky and allowing it would be unfair. However, we must be equally concerned and open to the possibility that it is our approach, not the innovation, which is unfair, and inflexibility may create barriers to competition in markets and in products that could increase value and lower costs for market participants.
Growth and the Broad Acceptance of Derivatives Markets
For a long time, the derivatives industry and its regulation was very much inside-the-box. Basically that box contained futures and options on agricultural commodities. In the mid 1960’s the Chicago Mercantile Exchange began to experiment with the trading of futures on perishable commodities. Prior to that point, many believed that successful contracts could only be traded on commodities that were highly storable, such as grains, soybeans and cotton. The CME took the bold step of listing a contract on live cattle in 1964, busting the myth of storability.
In 1971, the Bretton Woods Agreement, which established a system of fixed exchange rates, collapsed and thereby introduced exchange rate risk into the markets. The CME introduced futures contracts on foreign currency and international banks began offering forwards and arranging parallel loans (the precursor to currency swaps). Around the same time, interest rates began to rise and became more volatile. The Chicago Board of Trade introduced futures on interest rate products, an innovation that allowed the hedging of risks that, left to accumulate, could have threatened financial institutions and the US economy. Futures rapidly expanded beyond the realm of physical commodities into the era of financial futures. In fact, financial futures now account for about 80% of all futures trades, while agriculture accounts for less than 10%.
Another critical development occurred when, in 1973, Myron Scholes and Fischer Black published their groundbreaking research on the pricing of options and corporate liabilities. Prior to that time, the pricing of options was a rather ad hoc endeavor. Once Black and Scholes cracked the code on the options box, financial engineering was born and not only could investors properly price options, but they became much more adept at recognizing the existence of options in all sorts of business contracts and dealings. Risks could be identified, unbundled, then bought and sold with a variety of different characteristics. As a result, the demand for derivative instruments to manage the risk inherent in business activity grew and the derivatives markets, both exchange-traded and over-the-counter, took off.
In 1974, in the midst of the innovations that were taking place in the derivatives markets, an agency called the Commodity Futures Trading Commission was born. While the CFTC was created by Congress as an independent agency, it initially involved moving the Commodity Exchange Authority out of U.S. Department of Agriculture. Thus, the CFTC came into existence within a regulatory box called the Commodity Exchange Act and a mission to regulate a rapidly expanding and changing marketplace.
Because of concern about bucket shops, the regulatory box contained a stipulation that required that all futures contracts be traded on a CFTC-registered and regulated exchange. While this requirement had been in existence since the 1930’s, its existence in the 1980’s started to become problematic when international banks and financial engineers developed swaps contracts and a host of other derivative products that were designed to be customized and traded in a bilateral off-exchange environment. Suddenly, the regulatory box became a real constraint on innovation and threatened the ability of risk managers to lay off their exposures in an efficient way. Over time, the CFTC and Congress saw their way out of the regulatory box with a series of interpretations and eventual legislation that brought certainty to the OTC derivatives markets and ultimately allowed the OTC derivatives market and the derivatives exchanges to innovate and grow.
The Regulation of Derivatives Markets
While the CFTC has struggled to find its way out of the regulatory box, its regulatory mission remains unchanged. The agency remains committed to maintaining the market and financial integrity of the industry and to protecting customers from abusive practices. What has changed, however, is that the Commission has new tools with which to oversee the markets. Rather than relying on a set of fixed rules and regulations, the Commission, under the Commodity Futures Modernization Act (or the “CFMA”), which was adopted in 2000, relies on core principles to provide guidance to market participants. This gives innovators in the derivatives space much greater latitude in determining how to meet our critical regulatory objectives.
In addition to principles-based regulation, an important aspect of the CFMA is the flexible regulatory structure that can be applied to the variety of derivative market structures. Prior to 1990, all futures trades had to be conducted on an exchange. Since futures contracts bear pricing and structural similarities to other derivatives contracts, there was quite a heated debate over whether contracts such as swaps, forward rate agreements, interest rate caps and collars, and myriad other risk assets might be considered regulated under the CEA. As you can imagine, a determination that these contracts were futures contracts in light of an exchange-trading requirement would have been stifling to the derivatives industry.
The CFMA settled much of the debate by recognizing that various types of transactions, market structures and participants can be regulated in a variety of ways based on the underlying characteristics of the markets. For example, OTC markets typically involve customized transactions, so they are relatively less liquid in that there may be fewer counterparties with whom to trade, and to exit a contract one may have to return to the original counterparty to change terms. However, the markets for such contracts tend not to be considered susceptible to manipulation since prices for such contracts relate more specifically to the contract itself rather than to the broader market. As bilateral deals between relatively large and sophisticated counterparties, their proprietary nature means that the public interest is limited. As a result, the CFMA clarified that certain swap transactions between sophisticated counterparties are excluded from most provisions of the Act. On the other hand, where the general public is broadly involved in trading and the commodities involved present a higher potential for manipulation, the Commission’s role in regulating those markets is greater.
The Commission is now going through its periodic reauthorization. In the course of this deliberation, questions have been raised regarding the regulatory effectiveness of the CFMA and concern has been expressed over the explosive growth of the derivatives markets. There have been calls to “re-regulate” the markets. I mentioned earlier Warren Buffet’s remarks on derivatives contracts. Another area of increased debate has been with respect to energy markets, brought on mainly by high prices and profits in the industry, the collapse of Enron, and the revelation of widespread price misreporting in the natural gas markets. In reaction to these events, congressmen, senators, and energy users have all expressed a desire to more heavily regulate the energy derivatives markets by imposing, for example, greater reporting requirements on market users’ positions and the imposition of tighter daily price limits on energy futures.
What Warren Buffet and those advocating tighter controls on derivatives may not fully consider is that the prescriptive solutions advocated will not likely lower credit risks or increase liquidity, will not decrease volatility, and will certainly not lower prices (which is the desire of energy market critics); however, constraining or curtailing derivative market use through these measures may lower market quality and ultimately drive up the cost of using derivatives. Derivatives allow businesses and individuals manage risks. If we restrict access to financial derivatives because we do not like the credit risk or we halt trading in energy futures contracts because we do not like how far prices have moved in a day, we limit one’s ability to control risk. We do not eliminate risks when we curtail the use of derivatives -- we create risk.
Derivatives contracts are of great value to a market economy because of the ability they give to users to unbundle risk and transfer it to investors who are more willing to assume the risk or to use that risk to unbundle their own risks. As Fed Chairman Alan Greenspan observed in an address before the Futures Industry Association in 1999, the market risk that derivatives users assume when they enter into derivatives contracts must be less daunting to the user than the underlying exposures they are hedging or presumably they would never enter into them in the first place.
To be sure, one source of Mr. Buffet’s concern was not so much with the instruments themselves, but the underlying credit risk that builds when the value of derivatives move into and, for the counterparty, out of the money. Since derivatives by their construction are zero sum games, while the winning party to the contract gains on the contract itself, it comes at the cost of a higher credit exposure unless a mechanism exists to ameliorate the exposure. In the futures and options markets, that mechanism is, and has been for more than a century, the clearing house. Because the contracts settle on a daily basis, and possibly more frequently, losers are constantly paying up. The credit risk is minimized because the duration over which uncovered losses can build up is quite short. In essence, there is little or no incentive to default. It is also the case that, in the futures and options markets, contracts are standardized and trade in liquid settings. Thus, if a counterparty does default or fail to make timely payment of margins, the clearing firm can quickly liquidate positions to stem the losses.
OTC derivatives present a different challenge in terms of managing credit risk. Because there is normally no central counterparty, such as a clearinghouse, the management of credit risk falls more directly on counterparties to assess and account for the risk they face from counterparty defaults. These risks can be managed through collateral arrangements or by limiting derivative exposures to individual parties and spreading positions among parties, but these solutions are ad hoc. In the case of banks and derivative dealers, where counterparty credit risk may tend to accumulate, it becomes very important that risk managers understand the nature of the risk that they are assuming and, as a result, it is important that they can measure with some precision the impact of significant events on their portfolio.
The backlog in the confirmation of trades in the credit derivatives market has been the focus of the Federal Reserve Bank of New York and a group known as The Counterparty Risk Management Policy Group, headed by Gerald Corrigan, the managing director of Goldman Sachs and former New York Fed President. The existence of unconfirmed trades and uncertainty over the legal transfer of positions has created some uncertainty in the market, which has threatened its viability and growth.
In this instance, as with credit risk, the trade confirmation process in the futures and options markets has been standardized by the exchanges and their clearinghouses. In the OTC markets, however, the process has been more ad hoc due to the lack of a centralized entity to deal with confirms and assignments. Nonetheless, the industry has strong incentives to resolve the problem, and under the direction of the Fed, the International Swaps and Derivatives Association and the Managed Funds Association have developed a set of best practices and put forth sound mechanisms to clear it up. I believe that such cooperative efforts under the guidance of a regulator demonstrate the constructive role that a regulator can play in working with market players to prevent problems before they occur.
Another example of where regulators should and have exercised caution is with respect to regulatory capital requirements for banks. As Chairman Greenspan has pointed out, dictating specific regulatory capital requirements can be a dangerous practice since it can lead to regulatory arbitrage where banks tend to allocate more of their assets to where regulators have underestimated risks and allocate fewer assets to those areas where they overestimate the risks. Moreover, when regulators get too involved in the day-to-day regulation of entities or over represent their ability to prevent bad behavior, moral hazards develop. When investors come to believe that the government will guarantee or protect them against losses, their incentive to monitor their own behavior is diminished. In such cases, the frontline protections in the markets—that is, the market participants themselves—break down.
Unfortunately, no matter how well intentioned or capable regulators, the protection that we can offer can never be as efficient or effective as that which can be provided by the markets and market participants. For example, the CFTC brings numerous cases against firms and salespersons making fraudulent sales pitches to retail investors. In many cases, once the agency has closed down the operation, the money is gone. But if we can educate consumers to not place their money in such schemes in the first place, we could avoid the problems that follow. Of course an alternative would simply be to not permit any retail investors to put their money in risk assets. In such cases it would be easy for our enforcement lawyers and investigators to identify lawbreakers since anyone offering any contract to a retail investor would be breaking the law. But such draconian measures would deny retail investors the opportunity to place their money with legitimate, law abiding firms who can provide valuable tools to manage their risks and returns.
In addition to becoming overly protective, regulators must also avoid being captured by their industry for the purpose of protecting the competitive position of those already in a market or industry. While the phrase “regulatory capture” suggests some sort of nefarious agreement between regulators and their regulatees, it can arise quite innocently when a regulator depends upon the industry to provide information on market operation or fails to fully understand the nature of innovations.
In the derivatives industry, we are continually faced with new innovations, and we as regulators, must decide whether there are sound reasons for limiting access to the innovation. I have already mentioned a couple of areas where the Commission and/or Congress has played a role in permitting innovation. For example, by opening up and providing safe harbor to the OTC derivatives markets, the CFMA opened the derivatives markets to whole new groups of participants.
HedgeStreet is an example of a niche market that offers small sized binary option contracts on various commodities and economic indices. This market, which happens to be a designated contract market, operates over the internet with appeal primarily to a retail customer base. An important aspect to their business model is their ability to quickly develop and bring novel contracts to the marketplace. Whether one day HedgeStreet becomes a roaring success or fizzles has yet to be seen, but I can assure you that, in the early 1980’s, such an exchange would never have gotten off the ground given the long approval process for new contracts that existed under commodities laws at that time.
Today the Commission still faces challenges in assessing marketplace innovations. For instance, Eurex U.S., The Clearing Corporation, Eurex A.G., and Eurex Clearing have had a proposal in front of the Commission since March 2005 to approve a global clearing link between the exchanges and their clearinghouses. Such a link would provide significant capital and market efficiencies to customers wanting the flexibility to execute trades on different platforms globally or to carry trades in a single enterprise.
The regulatory challenge with the global clearing link has been that when trading and clearing occur across different, and in this case international, regulatory jurisdictions, questions arise as to who has jurisdiction, what country’s laws and rules apply, including those pertaining to bankruptcy, and whether the approval of such a link gives a regulatory advantage to the innovating market. Certainly an analysis of the global clearing link requires the Commission to perform its due diligence and be assured that our regulatory concerns are met. But in doing so, it may require us to think “outside the box” with an eye toward easing the way for an innovation that facilitates a seamless global marketplace. I am absolutely sure that in five or ten years, we will look back and wonder what all the fuss was about. Nonetheless, fuss is what we have now and the Commission needs to act.
Finally, I would like to address the increased scrutiny and requirements that have been meted out onto the managed fund industry, including hedge funds (many of which are already registered with the CFTC as Commodity Pool Operators or Commodity Trading Advisors), pension funds, and the financial firms that cater to them. More and more, we see criticism of these entities from sources that seem to be looking for simple answers to more complex problems.
There is no escaping the fact that energy prices are a source of consternation among energy consumers. But instead of looking for solutions to what appear to be chronic problems in the energy industry itself, many critics look to pin the blame on the energy derivative markets, which in this case has the unenviable task of being the bearer of bad news. More specifically, more often that not, the focus is on the managed funds industry. And the “solutions” that the critics have pushed are to focus on bringing more scrutiny to fund trading and to slow their ability to trade. I believe, however, that to impose such “solutions” will ultimately end up hurting the markets rather than helping the markets, and they certainly will do little to lower energy prices.
Earlier this year, economists at the CFTC completed a study of trading by managed money traders in the energy markets. What they found, contrary to the charge of critics, was that these traders tended to provide liquidity to large hedgers. They react to the demand for hedging services, creating a buffer to price movements rather than causing them to move excessively.
My point is that as a regulator we need to have confidence in the markets. We know that speculators and managed funds play a critical role in the markets by standing ready to buy and sell to hedgers. We also know that markets with only hedgers will never work. Such markets could never achieve the balance in and coordinated timing of hedging needs to sustain an active market. We also know that funds are not the mindless speculators that the CEA codified when it banned futures in the onion markets. Funds have become quite sophisticated in designing their trading systems. Many rely on information concerning the fundamental state of markets and bring critical information into the markets. They have to, or they would fail to survive for long. So it seems to me that rather than proposing regulations that would raise the cost of trading to managed funds or curtailing their activity in the markets, we should be concerned with assuring that they have adequate access to the markets.
In conclusion, the message I have tried to deliver here today is one of innovation and regulatory flexibility. Your business, and what you are here to discuss over the course of today and tomorrow, is about innovation. It is about looking for opportunities in new places, in markets that have not been a traditional vehicle for investment.
My business is regulation, but the message I hopefully have delivered is about the need for flexibility of regulation in the face of innovation. While regulators cannot cede their mission of market and customer protection, they cannot become so intransigent so as to stifle legitimate business innovation. When we do that, not only do we imperil business, but we raise costs for investors, both those who use markets and those who benefit from the existence of these markets.